Diversification is not enough to reduce market risk
Dividing your assets into different classes of stocks and bonds, as well as alternative investments like real estate and commodities, should protect you from market risk. Lately, though, we’ve seen stocks and bonds take a hit, which is very unusual. Michael Oyster, Chief Investment Officer at options solutions In Chicago, he has a better answer.
Larry Light: Diversification is worshiped in financial circles. It has been codified in modern portfolio theory.
Michael Oyster: When markets do what everyone hopes they will do, which is rise, the brilliance of Harry Markowitz’s modern portfolio theory is often celebrated.
After that, account balances increase, risks appear to be decreasing, or under control, and financial institutions are widely seen as real drivers of humanity.
Few financial theories have brought about such a positive change in the world as MPT. After its introduction in 1952, it helped institutional investors develop their investment portfolios into higher yield areas in the financial markets. This was a profound shift for conservatives that had historically been grounded in the perceived security of bonds. Higher returns from a diversified portfolio have enabled many organizations to do more good.
Mild: This sounds too good to be true.
oyster: Much has changed since 1952. We have learned through experience that price volatility, both up and down, which is the measure of risk in the MPT model, is not practical or even appropriate.
The risk that people really care about is the risk of losing, and herein lies a hard lesson that everyone eventually learns. There is a difference between models, markets, ivory towers and Wall Street.
Mild: Tell us how.
oyster: Financial models indicate that historically low correlations between investments of different asset classes can help to stabilize portfolios during periods of market stress. But most institutional portfolios derive nearly all of their risk from the whims of the stock market. We’ve learned this lesson over and over again, and every crisis seems to make this relationship stronger.
Observers who bemoan the short-term price volatility of institutional portfolios are often reprimanded by an elegant, but perhaps overly ambitious, description of the risks for perpetual institutions, something like this:
Risk is not volatility. It’s a permanent capital impairment, a loss that not even an unlimited amount of payback time can fix.
However, if that gives a full description of institutional risk, and no amount of short-term volatility ensues as long as the capital is never permanently diluted. Then the investment solution will be simple.
All institutions will invest 100% of their assets in the US stock market, which has skyrocketed throughout recorded history, despite short-term declines along the way. If only it were that easy.
Mild: What is the problem?
oyster: In fact, institutional investment portfolios are regulated for the long term, but the letter-related spending from those portfolios is more in the short term nature.
The multi-season settlement process helps, but even a short-term decline in the value of assets can put significant strain on mission-related funding. The thought of telling the leaders of an organization that they would have to find a way to do the same work for fewer dollars could keep anyone up at night.
What is really important? Should we strive to reduce volatility, or should we reduce the risk of loss? Stock market losses are often not mitigated by other assets in a “diversified” portfolio. In contrast, an option-based, carefully structured solution can objectively target and eliminate a specific, learning loss that is customized to the unique needs of the organization.
Mild: Tell us how this works.
oyster: Keep in mind: All else being equal, the value of the put option is expected to increase when the underlying stock or index falls. In most cases, if a stock investment is declining, a sell position is advanced, which can fully offset or eliminate the losses.
The problem with puts is that they are expensive. If an investor has no experience with options and then takes into account the cost of hedging the selling risk, they will often choose not to proceed after concluding that the risk mitigation provided by the offering is not large enough to justify the purchase price. For many, this is the last time they consider options as a hedge and the story ends.
Mild: But this is not the end of the story.
oyster: With a little creativity, a hedge created with options can provide the required level of risk protection at no cost. For example, you could have a hedge in the form of sell protection, which is funded by selling put options. In a different way, an investor can trade unlimited possibilities in the upside to protect against the downside.
Mild: What about bond risk?
oyster: Recently, investors have been reminded that many areas of fixed income are far from being risk-free and that bonds may not always provide the equity risk mitigation promised by diversification. Some fixed income ETFs offer deep options markets associated with them. The same options-based hedging techniques can be applied to mitigate interest rate risk, credit risk, etc.
Mild: What does the future look like?
oyster: In an environment of rising interest rates, persistent inflation and geopolitical uncertainty, institutions face unique challenges. Most portfolios show no greater threat to asset values than the risk of losing the stock market. To be sure, traditional concepts such as diversification may be ill-equipped to deal with. Selling options can be expensive, but their cost can be offset by giving up some positives, and perhaps a small sacrifice if future market returns are lower than in the past.
MPT got us this far, but future investment portfolios may benefit from explicitly targeted stock market risk protections that can be tailored to meet almost any risk or reward.